Gold Supply And Demand

Most markets work on a very simple principle of price and demand known as price elasticity, where market prices are completely elastic ( or relatively so). In other words if the price goes up due to over supply, then demand falls, and if the price falls due to lack of supply then demand rises. One can apply this very simple model to virtually any market or sector one cares to think of such as cars, holidays, clothes, food etc. So price and demand correlate inversely and the markets are said to be perfectly elastic. Now whilst demand explains the consumer side of buying decisions, what about the relationship between price and supply for the producers? The price supply relationship is the exact opposite of that of price demand. As prices rise so does supply, and as prices fall so will supply – the two correlate directly, which might appear strange at first glance, but if we stop to think it does make sense. If the market can only support a low price, then only the most efficient suppliers will compete, but as prices rise, more suppliers enter the market as even the inefficient producers are able to make a profit. Hence as prices rise, so does supply coming onto the market. If we add these two effects together then the market price is the point at which the two graphs meet and is where the level of demand will meet the level of supply, as shown in the chart alongside. So does the same model apply to the price of gold when you are trading spot futures or indeed trading in the physical commodity itself. The answer is categorically and emphatically NO, and the reason for this is very simple and very logical.

Gold, unlike many other commodities is not consumed, and therefore the traditional models and theories of supply and demand simply do not apply! There are, of course, several other reasons such as the finite amount available and the cost of entry to the market, but the key point is that deficits or excesses do not, and cannot affect the market price, for the simple reason that nothing has actually been consumed. In a sense all that is happening in the market is that the commodity is moved from one person’s stockpile ( the mining company ) to another person’s stockpile, the investor. Nothing has been gained or lost in terms of the commodity itself, and unlike James Bond’s adversary, Goldfinger, it would be impossible for one private investor to control the world’s stockpile. Of all the gold extracted from the relatively small number of mines, only a tiny fraction is ever “consumed” in the true sense, with the overwhelming production added to the ever growing stockpiles of governments, corporations and private investors, along small amounts of recycled scrap. For gold there is always a large stockpile and it never gets any smaller, it is simply the owners of the stockpile who change! So in looking at the market as a whole we need to consider the total supply and total demand compared one with another, and not simply the incremental increase or decrease on an annual basis.

Lets consider a simple example based on current estimates from the World Gold Council. Based on their figures the total weight of gold on the market is currently estimated at around 160,000 tonnes with global production at just over 2,500 tonnes a year. Suppose all mining stopped for a year with no new supplies entering the market, then this would represent only 2,500/160,000 or 1.5% of the total market – an almost insignificant amount, and remember this is based on a total closure of all the gold mines around the world. If we perhaps consider a more realistic example where total production falls from 2,500 tonnes to 2,000 tonnes, then as a percentage this represents less than 0.3% of the total market. Perhaps now you can start to see why the supply demand figures for gold, and their relationship to the market price are virtually meaningless.

Now in addition to the above, there is another reason that the supply and demand analysis often suggested as the reason for the rise or fall of gold prices, is complete nonsense, and it is this – the figures used are based on guesswork and half truth, not fact. The reason is very simple – much of the gold moves around the world in secret, particularly with the banks reporting or publishing only sketchy details, and most not at all. It is generally agreed that demand runs at around 3800 tonnes per year creating a so called “deficit” of around 1200 tonnes per year or 0.75% of the total stockpile! Hardly enough to move the market! There is no need at all for supply on an annual basis (excluding private sales) to come into balance with demand on an annual basis. It is not even true that these must balance over any number of years. The reason for this is that a sale out of someone’s stockpile of gold does not reduce the total amount of stockpiled gold – all it does is to shift the gold from the seller’s private stockpile to the buyer’s private stockpile. A market could remain in a “deficit” of this sort forever without the price ever going up (or going down) as buyers and seller shifted the contents of their stockpiles among themselves.

In summary, I hope from the above, that you can understand why I personally place no importance on the figures for supply and demand for gold which are often debated and discussed in the financial press and elsewhere – in my view they are meaningless and should be ignored as part of your trading decision.